After the Organization of the Petroleum Exporting Countries (OPEC) agreed to curtail production last fall, West Texas Intermediate (WTI) crude oil rose above $50 per barrel. But optimism in the oil market has recently faded. As of this morning, WTI was trading at about $43. (All figures are in U.S. dollars.)
But the drop doesn’t necessarily mean you should change your investing strategy, say Shane Obata and Chris Kerlow, CFAs, in a market report from Richardson GMP. Their advice today is the same as it was when oil peaked in January: “Stay underweight energy and focus on defensive names.”
Though there’s weakness at the sector level, “there has been some dispersion at the industry level,” says the report, with refiners and pipelines outperforming, while exploration and production, and equipment and services have underperformed the sectors.
On the credit side, high-yield energy is “finally starting to show signs of weakness,” and mergers and acquisitions activity is also drying up, with the volume of deals falling to its lowest level since early 2015.
“Royal Dutch Shell, Marathon and ConocoPhillips have been paring back investment,” says the report.
Though the macro view for oil is negative, “we are not in the business of buying and selling oil,” say the authors. “Our focus in on defensive companies that will continue to perform even if the downside risks come to fruition.”
That means being underweight energy with an emphasis on low-beta names such as TransCanada and Suncor.
And since it’s impossible to time the bottom, “we are adding to positions and will continue to do so if and when prices move lower,” they say.
The outlook for supply and demand
When it comes to compliance with the deal to cut oil production, Iraq has achieved only a 55% compliance rate this year, notes the report, and Venezuela and the United Arab Emirates have also been “less than perfect.” Countries such as Nigeria and Libya, which are exempt from the deal, have actually increased production.
U.S. output has also been growing, as technological improvements have allowed U.S. companies to raise output at lower costs. As a result, “many wells that were not previously economically viable are now, even with oil around $50.” The average prices needed to cover operating expenses at existing wells range from $24 to $38, says the report, citing the Dallas Fed.
New wells break even from $46 to $55. That means if oil stays at current levels or falls, drilling activity should slow. And “with better operating margins and lower cost structures, it is likely that production will be more resilient than it was last time around,” says the report.
On the supply side, the view is decidedly bright, with global oil demand expected to rise by 1.3% in 2017, though the report notes that that figure represents a deceleration relative to the 1.7% and 2.1% seen in 2016 and 2015, respectively.
Still, non-OPEC countries like China and India are expected to drive supply, despite headwinds for global growth.
Read the full report.